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Decoding Wall Street

DECODING WALL ST ALGORITHMS – the difference between you and the people who actually make money on Wall Street What Are Algorithms? Algorithms are the math computers use to make decisions. ALGORITHM Use advanced Make predictions 1 They process huge data sets based om probability. math to find patterns Algorithms are used in well-known products, like: Google Search Amazon Book Recommendation Google amazon Financial Algorithms Algorithms are also used in investing. Financial engineers create algorithms to analyze and buy or sell stocks, and other financial instruments automatically. In the past 10 years, algorithmic trading has become a huge factor in trading. 75% VOLUME of today's global markets is driven by algorithms. 75% volume is .. . 25% volume is executed by humans executed by algorithms (73% done by high frequency shops) Incredible Performance Funds that use algorithmic strategies exclusively have performed exceptionally well historically, beating benchmark indexes. Total returns for the past five years: 465% 371% 293% -0.75% Benchmark S&P 500 Index Industry Leader Renaissance Medallion Fund Industry Leader SAC Capital Industry Leader PDT Advisors The Algorithm Advantage Algorithms have changed the global investment game, putting individual investors at a major disadvantage to investment banks and hedge funds. Here are some of the reasons why: Advantage 1: Process More, and Faster Algorithms take advantage of computers' ability to process data. They can compare price and metrics of millions of financial instruments faster than individuals. Advantage 2: Emotionless Emotions can get in the way of sound investing, causing many to buy when prices are going up and sell when they are going down. In contrast, algorithms buy when the market prediction says buy. 1,000 Shares WAIT! SELL! NO!!!! BUY Advantage 3: Execute Faster Algorithms are operated on computers, which react faster than humans to market changes. With low-latency fiber optic cables" connecting the world's biggest markets, algorithms can trade near the speed of light, which is significantly faster than your WiFi connection. There and back in ỔNDON 5,443 km W YORK 55.7 milliseconds 2x faster than the average blink "Banks and funds pay millions of dollars a year to access these networks, but they use algorithns to take advantage of the speed. Advantage 4: Manage Risk Algorithmic strategies can be developed to make calculated decisions balancing risk and reward to maximize profits and minimize losses. Stop-Loss controls can be added to automatically liquidate a position if an algorithm loses more than an defined percentage. Risk algorithms are also used to manage correlated instruments in a portfolio, limiting exposure to big losses. Oil price Canadian Dollar Positive correlation Potential risk Potential reward high Types of Algorithms Investment managers may use algorithms to analyze trades, and buy or sell manually based on the algorithm's suggestions, or may allow the algorithm to trade automatically, intervening on occasion. Algorithms that are 100% automatic are called black box because the decision-making process is hidden in code. BLACK BOX human intervention DISCRETIONARY TRADING 100% AUTOMATIC An algorithmic investment system is made up of algorithms that fulfill specific functions. Alpha Model Risk Model Transaction Cost Model Predicts future profitability of instruments in portfolio Limits exposure to assets with high risk and low reward Verifies that potential profits are greater costs of trades Portfolio Construction Model Determines ideal portfolio holdings based on input of alpha, risk and cost models, and makes trade orders. Execution Model Analyzes the trade orders and the liquidity of the market to place orders in the most efficient way, for the best price Source: Inside the Black Box Algorithmic Strategies Below are a few types of strategies that are commonly used in algorithmic trading. TREND MEAN FOLLOWING REVERSION ARBITRAGE These strategies follow general trends in a set of data strategies is that stocks have by comparing historical and current prices, profiting whether prices go up or down These strategies depend on speed imbalances between different The philosophy behind these catch price an average price over time. They use historical data to compute an average price. markets. NEWS READING HUMAN SENTIMENT SCALPING These strategies scan the news and invest based on what is happening in the world. News wires have been These strategies scan social networks and make trades influenced by how anxious or positive people feel. These strategies act like market makers, and make small profits on differences in a bid/ask spread. adapted for these algorithms. HIGH FREQUENCY TRADING ICEBERGING STEALTH Operating at the millisecond level, these strategies use arbitrage or scalping techniques at high volumes and super fast speeds. This cost-reduction strategy works to conceal large orders by breaking them into smaller orders, executed over time. The strategy of these algorithms is to uncover the large iceberged orders that have been cut into smaller orders. Criticism for Algorithms Algoritmic trading, specifically high frequency strategies have come under criticism in the past few years. According to a study by the British research group Foresight, "While no systematic evidence that HFT reduced stability, the interactions between algorithms may cause instability different from interactions between human." Algorithms have been blamed for: LONG-TERM CAPITAL FLASH CRASH MANAGEMENT - MAY 6 2010- -1998- The quant hedge fund was highly leveraged in the fixed-income market that went bust when Russia defaulted on their bonds. The Waddell & Reed Financial Inc., a mutual fund ran an execution algorithm that set off a feedback loop among HFT, sparking the largest intraday dip in the Dow's history-998.50 points. Federal Government organized a bailout to a avoid global financial crisis. BETTER ALTERNATIVE TRADING SYSTEM (BATS) IPO - MARCH 2012- At the IPO of the BATS electronic exchanges, a trading glitch drove the stock's shares from their opening price of $15.25 to 3.8 cents, forcing the company to halt trading and withdraw their IPO. On the same day, Apple stocks dropped 9% on one share on BATS Global Exchange. Made by Quants Financial algorithms are written by quants, or quantitative analysts. Quants use computer programming languages to design algorithms, drawing on advanced math techniques, and physics and as well as knowledge of financial markets. Algorithms are commonly written in: C++ Java C# While there are several degree programs, many top quant shops hire based on skills in science and math, with no background in finance required. According to QuantNet, the top five Masters programs in 2011 were: INSTITUTION DEGREE Carnegie Mellon University Computational Finance Princeton University Master in Finance Columbia University Financial Engineering 4 New York University Mathematics in Finance Baruch College Financial Engineering SOURCES: Kevin Slavin: How Algorithms Shape Our World- Ted.com Inside the Black Box: The Simple Truth About Quantita- tive Trading-Riohi K Narang http://www.led.comtalkslanglenkevin_slavin_how_algorith ms shape_our_world.html Long-Term Capital Management-Investopedia http://www.investopedia.comtermsMongtermcapital.aspša xzz22KkYpb79 Is the Market Rigged? http:/Minance. yahoo.comtiogsidaily-ticketimarket-rigged- absolutely-says stroettalk-advisors-ceo-174425615.html Trading at the Gpeed of Light-Bloomberg Businos- weok, Matthew Philips http://www.businessweek.com/articles 2012-03-29.trading- at-the-speed-of-light How a Trading Algorithm Wont Awry-WSJ.com, Tom Lauricella, Kara Scannell and Jenny Strasburg http://online.wsj.comlarticle SB10001424052748704029304 575526390131916792 hemil Dow Takes a Harrowing 1,010.14-Point Trip-WSJ.com, Tom Louricella and Peter A. Mckay New York-London Fiber Optic http://www.hiberniaatlantic.comsenvices html http://online.wsj.comlarticle SB10001424052748704370704 575227754131412596.htmi Algorithms Take Control of Wal Street-Wired, Felix Salmon and John Stokeg http://www.wired.com/magazine2010/12_ai_lashtrading BATS IPO Canceled in Share Craph-The Street. eGara http://www.thestreet.com/story/11468126/1/bats-global- flash-crashes-on-ipo.html Blink Speed http://bionumbers hms.harvard.edubionumber.aspx?s-y&i d-100706& ver-0 The Bats Affair: When Machines Humiliate Their Algorithmic Trading b iedia.org/wikiAgorithmic_tradingfcite_note- Mastero-BLoomberg Businesoweok, Brian Bremner http://www.businessweek.com/articles2012-03-23.the- bats-aflair-when-machines-humiliate-their-masters 54 Foresight Study http://www.bis.govukforesightlour-work/projecta/current- projectsicomputer-trading'working-paper Apple Flash Crash: Stock Halted Aftor Trade Causes 9% Plunge-CNBC, John Melloy http://www.anbc.comidi46835129Apple_Flash Crash_Sto ck_Halted After_Trade_Causes_9_Plunge Wikipedia Quantitative Analyot http:/len wikipedia.org/wkiOuantitative_aralystAlgorithmi _trading_quantitative_aralyst QuantNet https://www.quantnet.com/pagesmte programe-rarkings QUANTCONNECT www.quantconnect.com B•ROR.

Decoding Wall Street

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This infographic explains the industry of algorithmic finance, offering insight into how it works, the prevalence, and different kinds of algorithms used for investment.

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